Portfolio Managers versus Money Managers

In my opinion there is an enormous amount of confusion about who the players are in the investment industry so here is my particular take on the subject.  I define portfolio managers as investors who have the freedom to invest in multiple asset classes.  Their portfolios are typically constructed with investments in U.S. and international stocks, U.S. and international bonds, U.S. and international real estate, commodities, and other exotic asset classes like managed futures, hedge funds, private equity, etc.  While they have the freedom to invest in any mix of these assets that they like, in the traditional world of buy and hold strategic asset allocation virtually all portfolio managers subscribe to Modern Portfolio Theory to come up with the single best or most “efficient” mix of asset classes.   The end result for portfolio managers is that the mix of the asset classes they choose never needs to be changed because markets are presumed to be efficient and investors are presumed to be rationale.  In short, traditional buy and hold portfolio managers buy and hold asset classes in a fixed mix that changes very little over time while they patiently wait for the past performance of each asset class to materialize.

Portfolio managers invest with money managers like mutual fund managers or separate account managers to invest each asset class in the portfolio.  A money manager usually is an expert in managing assets in one asset class, and his or her portfolio performance is compared to a one asset class benchmark.  You can find money managers specializing in virtually any asset class, including all of the ones mentioned above.  These are the managers who buy and sell individual stocks and bonds as institutional investors, and these are the managers you see on TV who comment on the current state of the markets.  They have an immediate and vested interest in the financial news of the day as they actively manage their portfolios to try and beat their one style constrained performance benchmark.  For example, a large cap value mutual fund manager who is trying to outperform the S&P 500 Index.

For most retail investors, their financial advisor acts as a portfolio manager.  They invest in money managers in the form of mutual funds and separate accounts in order to own multiple asset classes in their client’s portfolio.  If they are a traditional buy and hold advisor, once they buy these funds, there is little to do but explain how they perform to clients, check their relative performance once a year or so, and remind their clients to be patient until expected returns arrive, presumably some time in the future.  Do not confuse these two types of managers.  A portfolio manager who passively invests in money managers is not practicing “active” management.  In contrast, Pinnacle Advisory Group actively manages portfolios at the asset class level.  There is a huge difference between actively changing the asset allocation of a portfolio management versus passively owning active money managers in a portfolio.  Don’t confuse the two.

Paul McCulley Strikes Again

Paul McCulley is the managing director of Pimco (Pacific Investment Management Co., one of the largest bond investors in the world) and each month he writes a piece called Global Central Bank Focus. This month, in an essay called, “Because I Said So…,” McCulley discusses the “old” rules for Central Bank policy for fighting inflation and relates the “new rules” for inflation fighting to parents who sometimes tell their children, “Because I said so.” I can’t do full justice to the piece on the blog so please read it for yourself at:

http://www.pimco.com/LeftNav/Featured+Market+Commentary/FF/2009/McCulley+Sept+Because+I+Said+So.htm

 For those of you who are not economic wonks, McCulley reminds us that for many decades our central bank has targeted inflation without regard to the prices of assets or the impact of potential future asset bubbles. The rule for inflation targeting is called The Taylor Rule after economist John Taylor. The rule suggests the elements for the inflation targeting equation are: 1) The neutral rate of inflation that would theoretically exist if inflation and employment were both at “target,” 2) The inflation rate itself, 3) The gap between actual inflation and target inflation, and 4) the gap between the actual unemployment rate and the theoretical “full” unemployment rate. McCulley points out that asset prices are nowhere to be found in this equation for targeting inflation, and that U.S. central bank policy has been to suggest that asset prices are implied by the other inputs to the Taylor Rule, so the Federal Reserve doesn’t need to forecast asset bubbles as they appear in the economy. The stated policy is to wait for the bubbles to burst and then use a “mop up” strategy when the bubbles actually do burst.

Well….its clear that something has to change in our approach to asset bubbles, and McCulley opines that in the future the Fed will have to take a countercyclical approach to policy that “leans against” boom bust cycles by changing capital/margin requirements for banks and by reforming the bankruptcy laws. But what really caught my eye were McCulley’s final thoughts about forecasting asset bubbles and creating new paths for central bank policy, since forecasting is a subject we spend a great deal of time studying here at Pinnacle. He says, “Yes, that will sometimes mean taking action that is not fully anticipated, based on old rules of the game. But just like parents, central banks (read money managers) must exercise judgment, and sometimes, good judgment does involve making decisions on the basis of where the gut says the brain is going.” Thanks, Paul. I couldn’t have said it better myself!

Do You Hear That Sigh of Relief?

The stock market has come rocketing off the March 9th lows and the rally is now at 50%+ and counting. Buy and Hold investors who had been holding their breath and hoping that something positive would occur in the markets to rescue their portfolio are wondering if their prayers have been answered. Even though the S&P 500 is trading 35% below its October 2007 peak, and is still trading below its March of 2000 value, and even though portfolio returns have dramatically underperformed any reasonable and conservative estimate of growth for a decade, you can hear the strategic buy and hold crowd breathing a huge sigh of relief.

50% market rallies do a wonderful job of helping investors take their eye off the ball. While six months ago the media was screaming that buy and hold is dead, now that story is being put into mothballs while writers scramble to cover the next bull market. How sad. The buy and hold is dead story has nothing to do with short-term market fireworks in either direction, and everything to do with a theory that supposes that such extreme market volatility shouldn’t be happening in the first place. Active portfolio management is all about understanding the intersection of traditional market valuation, economic cycles, and investor behavior as measured by market sentiment and market breadth. It is worth repeating that classic modern portfolio theory and the efficient markets hypothesis (buy and hold) refute the need for any of the above. In theory, buy and hold investors can sit back and wait for anticipated returns to appear right on schedule, which is some unspecified time in the future. This remains a dangerous strategy for investors.

I am personally enjoying returning to my former status of investment genius as the bull market continues. The 2003 – 2007 bull market seems like it occurred a long time ago and I am not immune to feeling great about excellent year-to-date portfolio returns. But cyclical rallies in secular bear markets do not make the case for buy and hold investing. These are the rallies that need to be invested with caution and respect. Buy and hold investors who are just now looking up to see if the coast is clear just might be heart broken as structural headwinds inevitably crush buy and hold returns in a continuing secular bear market.

A Tax Test May Be Coming Soon

In my book, Buy and Hold is Dead (AGAIN), the Case for Active Management in Dangerous Markets, I devote an entire chapter to portfolio tax planning. The tax chapter is called, The Tax Tail and the Portfolio Dog. The title refers to an old saying about taxes that basically means that investors shouldn’t let tax considerations outweigh value considerations when making asset allocation decisions. The chapter borrows heavily from the work of Michael Kitces, Director of Research at Pinnacle Advisory Group, who points out that unless you die with appreciated securities in a taxable portfolio and get the currently allowed step up in tax basis, the value of most tax strategies is limited to the value of tax deferral. The chapter goes into great detail to show that the value of tax deferral is not as great as most people think it is, and the resulting conclusion for value investors is simple…don’t let tax considerations keep you from selling overvalued assets.

It is possible that this year will put many investors to the test regarding realizing capital gains in actively managed portfolios. The speed and magnitude of the current stock market rally is such that investors will be forced to look at the value proposition of holdings that may have doubled in value since March of this year. If by year-end investors conclude that holdings are overvalued, and if they were purchased within the past 12 months, then they will have to weigh the tax cost of short-term capital gains versus the risk of holding securities for the full 12 month period needed to get the more favorable long-term capital gains tax rate. For savvy investors who bought the market after the severe post-Lehman Brothers market decline in September, they will be “playing chicken” with the markets as they approach their 12 month holding period. Investors with the best market timing will have to hold until next March to get to the favorable long-term rate.

For the record, if you own a security with a 20% gain it only has to retrace 3.06% of its value to completely wipe out the benefits of short-term versus long-term capital gains (assuming 28% short-term gain rates and 15% long-term rates). For 50% gains the breakeven pullback is 7.65% and for 100% gains the breakeven is only 15.29%. Students of market volatility would conclude that the potential for losses from overvalued levels should lead investors who want to protect their profits to go ahead and take them without worrying too much about tax costs in the transaction. Of course, investors may have large amounts of loss carryforwards, or unrealized losses that can be realized in their portfolios in order to offset gains this year. It will be interesting to observe investor tax behavior as we approach the end of the year.

Looking for the Right Word

I have no problem with describing Modern Portfolio Theory as science. After all, Markowitz’s work did win a Nobel Prize for Economics, and for that matter, so did Bill Sharpe’s work on the Capital Asset Pricing Model. I believe that investor’s want to pay for science…and all that it implies. Science implies certainty, exactness, facts versus opinion, expertise, proof, and so on. Since investor’s want to buy science, it should be no surprise that investment advisors want to sell science. For four decades now the financial industry has successfully sold strategic asset allocation as science. But now that the problems with MPT are becoming well known, consumers of investment advice need to reevaluate the value proposition of any investment process that claims to be scientific.

I am still looking for the right word to describe active portfolio management where the decision making process is driven by a subjective, qualitative approach to asset allocation. I have described it as “art,” the antithesis of science. In my book, Buy and Hold is Dead (AGAIN), I contrast art with science as saying that art “lies in the eyes of the beholder.” One investor’s interpretation of the economic facts of the day can and will be different from another investor looking at the exact same data set. The experience, judgment, and wisdom that help an investor reach a conclusion are art, I said. The problem being that art conjures up all of the wrong images. Artists are erratic; art is hard to measure and impossible to repeat. If investing is art than it must be about guessing, hunches, flashes, intuition, and other non-sellable attributes.

So this morning I want to suggest active management as a craft. Yes, craftsmen are still artists, but it seems to me that we value craftsmen. If investing is a craft to be learned, then we imagine that it takes skill and not luck. We expect craftsmen to apprentice for years before they practice on their own because a craft takes judgment and experience, in a context that we value and appreciate. So for now on, I think I’ll describe investing as a craft to be learned. While everyone is not an equally good craftsman, we can all agree that the best of them deserve our respect and are worthy of our patronage.

The Surprising Mathematics of Defending Market Declines

The mathematics of portfolio declines and recoveries are somewhat counterintuitive. You would think that if your portfolio declines by 50% that you would need the portfolio to rally by 50% to get back to even. But that’s not true at all. The following simple chart shows the relationship between portfolio declines and portfolio recoveries:

When you consider how a 50% decline requires a 100% rally to break even, and a 70% decline requires a 233% rally to break even, you can see why defending against dramatic portfolio declines is important. As it turns out, the actual S&P 500 decline is 57% from the October 9, 2007 high of 1,565 to the March 9, 2009 low of 676 (including dividends the decline is 55%). The recovery as of last Friday’s closing price of 1,004 is 48.5%, or 50% including dividends. Even though the decline was 55% and the recovery has been 50%, the index still needs to rally an additional 56% just to get back to the October 2007 highs!

What would happen if an investor only captured 50% of the market decline and then captured 50% of the latest rally? Once again the numbers might be counterintuitive to some. An investor with a portfolio valued at $1,565 would have seen their portfolio value decline by 27.5% (one half of the 55% decline) to a value of $1,134. Then the portfolio would have rallied by 25% (one half of the S&P rally of 50%) to a value of $1,417. The portfolio would only be 10% below its starting value, as opposed to the current S&P dilemma of needing a 56% rally to get back to even. As it turns out, Pinnacle’s Moderate Growth portfolios have a similar ratio of downside and upside capture. Our Appreciation portfolios have done even better with the downside capture being contained but the upside capture being much higher as a percentage of the market. As we work through the entire cycle, defending against large losses has served our clients well.